On April 7 the Securities and Exchange Commission delisted the shares of China Changjiang Mining & New Energy Co. Ltd. from the OTC Bulletin Board, an over-the-counter trading system for companies with a market cap too small to be traded on Nasdaq.
The delisting was a fitting end for CCMNE, a stock that had flouted the rules since it gained access to the U.S. public market in 2008. The company came into being Feb. 4, 2008, when a group of Chinese investors acquired North American Gaming & Entertainment Corp., a Nevada-incorporated shell company. The investors said they planned to use CCMNE as a vehicle to acquire or merge with operating businesses.
CCMNE's books became questionable almost immediately, although the full scope of the problems didn't come to light until March 31 of this year when the company disclosed in an SEC filing that its original auditor, Brock, Schechter & Polakoff LLP, had resigned almost four months before. The company, now employing a new auditor, also revealed that during fiscal 2009 and 2008 there had been ongoing disagreements with Brock Schechter over concerns about CCMNE's ability to continue as a going concern, the value of goodwill on the company's balance sheet and the company's internal controls. The day after the revelations, the SEC suspended trading in CCMNE. Delisting came a week later.
The episode was one of a string of SEC enforcement actions against so-called reverse mergers, a type of transaction that allows private companies to go public without the legal or accounting fees of registering an initial public offering with the SEC. A reverse merger is a legitimate tactic, but one that is vulnerable to abuse. The SEC has said it is harder to obtain reliable information from reverse merger companies, particularly those based overseas, and issued a warning to investors in June.
The attention being given to reverse mergers is an outgrowth of an SEC initiative begun in the summer of 2010 to look more closely at the books of companies with foreign operations. In recent months the SEC and U.S. exchanges have suspended or halted trading in more than 35 companies based overseas, citing a lack of current and accurate information about the firms and their finances. These included a number of companies that were formed by reverse mergers.
The SEC, on Nov. 9, moved to reduce the potential for abuse by imposing new limits on companies seeking to list on exchanges through reverse mergers. The new rules prohibit a reverse merger company from applying to list on Nasdaq, the New York Stock Exchange and NYSE Amex until it has completed a one-year "seasoning period," trading on the U.S. OTC Bulletin Board or on another regulated U.S. or foreign exchange. The company must file all required reports with the commission and maintain a minimum share price for at least 30 of the 60 trading days before its listing application and the exchange's decision to list.
"Placing heightened requirements on reverse merger companies before they can become listed on an exchange will provide greater protections for investors," SEC Chairwoman Mary Schapiro said in a statement accompanying the changes. A company generally would be exempt if the listing is in conjunction with a "Form 10 IPO," a process small companies can use to conduct an IPO by merging with a newly created shell company. The IPO must have an underwriter's commitment to acquire unsold shares. A company would also be exempt if it has filed at least four audited annual reports with the SEC since the reverse merger occurred.
Jones Day partner Joan McKown, a former chief counsel of the SEC's division of enforcement, praises the SEC rule changes as an "incremental ratcheting up" by the SEC and "a smart way to go."
She notes that Chinese companies might be a particularly enticing vehicle because of the heightened investor interest in the sector and the increasing use of reverse mergers by Chinese firms. A study by the Public Company Accounting Oversight Board found that from 2007 through March 2010, 159 Chinese companies listed in the U.S. through reverse mergers. Of six reverse merger companies that have had trading suspension imposed this year, four are Chinese.
Shell company acquisitions have been rife with fraud in the past -- in the 1980s they were popular with penny stock operators hyping overvalued shares to unsuspecting investors. McKown notes that lack of business operations, small float and little attention from the press or the larger investment community make them attractive to manipulators. "If there are things you want to hide, this is one way to do it," she says.
That overseas scammers have discovered that the weakness of reverse mergers, she says, is simply one of the "latest challenges of a globalized securities market."
Bill McConnell is The Deal magazine's Washington bureau chief.